How Will Tax Cut Expirations Affect Funds?

Unless a compromise is made between the White House and Congress, investors could face significant tax hikes when the Bush-era tax cuts expire at the end of the year. Although most experts are confident that a last-minute deal will be struck, it may be a temporary one-year patch.

How dividends and capital gains are taxed in the future could have an impact on how companies return money to shareholders and how fund managers view their holdings. Analyst opinions differ on what exactly the impacts will be but in any case, dividends will still likely be the most attractive income option for stock and fund investors.

For investors with dividend-paying stocks or funds held in a tax-deferred account such as a Roth IRA or a 401(k), there will be no immediate impact, since tax rates are negligible. But it could impact how companies pay dividends and that could indirectly affect how fund managers view those positions and pay dividends themselves.

Sam Stovall, chief equities strategist at S&P Capital IQ, says if no compromise is made, some investors and fund managers may take profits in high-dividend stocks before the end of the year. He says others may just sit still because if they’re holding those stocks for income, there are few other options. With CDs and Treasuries paying pitiful rates, there are few other better alternatives for yield or income out there.

“If you sold your stocks or funds [because of a dividend tax increase], where would you go?” says Stovall. “You’re going to get taxed on your bond income at the same rate as your dividend income. So it’s still a better deal.”

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